Uncertainty on bourses

INSIGHT

The markets are playing safe with the budget round the corner. Although the broad market indices have shown strength after the Sensex reached the 10000 mark, the derivatives market is giving signs of doubts on whether the markets will remain at these lofty levels.

To start with, not only are Nifty futures trading at a discount to spot value of the Nifty, but it also turns out that the discount increases progressively with an increase in the period till expiry of the contract.

This is the opposite of how things should be theoretically. Futures prices are supposed to be higher than the spot value of a commodity or a stock (or any underlying, for that matter), to account for the interest cost associated with the difference in the time period of delivery.

Stocks purchased in the spot (cash) market have to be paid for immediately, but those purchased in the futures market have to be paid for at a future date. The higher the time period after which the payment has to be made, the greater the interest cost that must be reflected in the futures price.

Thus, theoretically, the future price must be higher with an increase in the expiry period. The fact that the trend with the Nifty (which represents the broad market) is opposite probably means that traders expect the markets to be lower than current levels in the future.

Of course, the Indian markets aren’t efficient enough for traders to arbitrage and gain from this price discrepancy. But, on the whole, it’s fair to say that the discount points to cautiousness about the future.

The fact that derivatives traders are treading cautiously is also reflected in options prices, which are disproportionately higher for contracts with a later expiry. Based on current prices, a put option for (that is the right to sell) a Nifty February contract can be bought at Rs 33.9 with the strike price at 3000, but a similar contract with a March expiry is available at Rs 103.15.

The implied volatility on the February contract is 23.5% using a risk-free interest rate of 8%, while that of the March contract is rather high at 30%. The fact that the markets expect higher volatility with the contract expiring in March simply points to the uncertainty about what the budget holds for the markets.

Sectoral swings tango 2005
It’s been nearly three years since the current rally in the markets began, and the Sensex has risen about 250% during this period. The rally has been rather broad-based, with most sectors participating in the rally.

Market analysts point out that traders have shifted between sectors throughout the rally, making sure that all sectors get to participate.

This year, though, it seems like traders have stuck mainly to the winners of 2005. Except in a few cases, there hasn’t been much shifting done between sectors. A look at the returns of BSE’s sectoral indices shows that the major gainers this year were also among the top performers last year.

The consumer durables index has been ignored simply because it’s driven mainly by one stock, Titan Industries, which is highly speculative in nature. Apart from this index, the capital goods, FMCG and auto indices had outperformed the Sensex by a reasonable margin last year.

Each of these indices has outperformed the market even this year, and by a fair margin too (See table). This simply points to the fact that the growth stories identified last year continue to drive stocks this year. Of course, the trend may differ a bit with individual stocks, but the sectoral indices do suggest that the outperformers of 2005 continue to lead this year as well.

Similarly, the oil & gas, banking and PSU indices had underperformed the market last year, and have continued to do so this year. The only exception in this theory is the healthcare (pharma) index, which has been an outperformer this year, after underperforming the market by a huge margin in 2005.

The reasons for this are positive news flow on one hand, and a low base from the previous year, on the other.

Otherwise, the markets seem to be sticking with growth stories such as capital goods and engineering companies, which are expected to continue growing at high rates thanks to their huge order backlogs. In the case of FMCG and Auto, the rise in disposable income and the pick-up in the rural economy seem to be the reasons the markets are banking on these stocks.

(Contributed by Mobis Philipose)